The core idea behind a value-add investment is to acquire a property at a discount to its replacement cost, and then to improve it. Often, these improvements can take the form of major renovations or enhancements that render some or all of the leasable space uninhabitable for a period of time.
Once the renovations are complete, the property enters the first of two types of ownership periods: lease-up and stabilization. The required management activities during each are very different.
What is the Lease-Up Period?
Once the renovations are complete, the lease-up period begins—typically, with an empty or mostly empty property—and it is characterized by an active effort to fill the space with rent-paying tenants. Activities during the lease-up period include things like:
- Marketing: During the lease-up period, there is an active marketing effort to find tenants interested in leasing space. In many cases, this includes hiring a commercial property broker to advertise the space on listing aggregation sites like Loopnet, and to actively reach out to potential tenants who they think might be interested in the space.
- Property Tours: Interested tenants may be given a property tour so that they can see the space for themselves, along with the amenities, parking, and the surrounding market.
- Lease Negotiations: If the tenant is interested in proceeding to a lease, it may take weeks or even months to negotiate the terms of the lease and to get it signed by all necessary parties.
The length of the lease-up period is determined by a number of factors that include starting occupancy, market demand, property type, property size, and the local absorption rate. In most cases, it is within the range of 12-24 months, but it can vary widely.
Understanding the duration of the lease-up period is important for two reasons: First, each new lease represents additional income and is effectively one step closer to the property being cash flow positive. Second, it is not uncommon for an investor to take on a short term loan to fund the property’s acquisition and renovations. In order to refinance it into a permanent loan, they need to complete the lease-up before the loan’s term expires.
The lease-up period ends when the property is at or near full occupancy, and the Net Operating Income (NOI) is sufficient to support a permanent loan payment based on the prevailing interest rate and the lender’s LTV, DSCR, and other underwriting requirements. At this point, the property moves into the stabilization period.
What is The Stabilization Period?
The stabilized occupancy period is characterized by a full or mostly full property with tenants who are paying rent on a monthly basis. At this point, the activities required for the property shift from concern over filling it, to concern over managing it. Typical management activities for a stabilized property include things like:
- Collecting rent and managing delinquencies
- Making loan payments
- Responding to repair requests
- Regular maintenance for things like landscaping, HVAC, and plumbing
- Monitoring lease expirations and negotiating renewals when necessary
- Monitoring rental rates for comparable properties and incorporating increases when possible
- Investor reporting
- Monitoring comparable sales and deciding upon the correct time to sell
In short, the stabilization period is primarily about maintaining the property’s occupancy rate and keeping it in good condition so that it will be attractive to potential buyers when it comes time to sell. The length of the stabilization period is highly dependent upon the owner’s desired holding period, general market conditions, and the property’s valuation. In many cases, it can last from 5-10 years or even longer.
The major reason that stabilization is important also has to do with the property’s financing. Depending on the lender, a property may have to exhibit stabilized occupancy for a certain period of time to be eligible for a permanent loan. This is particularly true for FNMA and/or Freddie Mac loans on multifamily properties, which must exhibit some level of stabilization for the best terms.
Lease Up, Stabilization, and Underwriting
Prior to allocating capital to a new property, investors must create a pro forma projection of future income, operating expenses, and cash available for debt service. This task is made harder by trying to figure out how quickly the property will be leased up. If investors assume six months and base their financing strategy on this assumption, there could be potential issues if it actually takes 18 months. In a worst-case scenario, the investor would be unable to refinance out of the short-term loan, which could lead to default and foreclosure. For this reason, it is critically important that lease-up assumptions be conservative, data-driven, and consistent with market trends.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.